Defaulted loans - looming in the background if participant tries to bo

[MR]

Suppose your client, before you took over the plan, ran a loose loan ship and allowed participant loans without requiring repayment via payroll deduction. Much to his surprise, some of the loans went into default. Now a participant who defaulted on a prior loan wishes to borrow again. I think his defaulted loan balance, regardless of when the default occurred, counts as part of his balance for purposes of determining the maximim available amount. For example, suppose I had a balance two years ago of $20,000 and I borrowed $10,000 and did not make any repayments. I defaulted on the loan and was issued a 1099R for $10,000. Now, my non-loan balance has grown back to $20,000 again and I look to borrow. I think my plan balance is $30,000 (actual cash balance plus defaulted loan of $10,000), so the maximum outstanding loan amount would be $15,000. Since my existing balance is already $10,000, I can only borrow another $5,000. Forgetting all of the reasons why it might not be prudent to let me borrow from the plan again given my history, is the math right?

[Kirk Maldonado]

I seem to recall that the recently issued loan regulations take that same position; that the amount of a defaulted loan is taken into account in determining the maximum amount that a participant can borrow (in the form of a new loan).

[Guest PC]

Q&A 13 of Treas. Reg. 1.72(p)-1 makes a distinction between deemed distributions and actual distributions. If your plan is a profit sharing plan that offsets account balances immediately upon loan default, you have an actual distribution. If your plan is a money purchase or 401(k) plan and your participant is not eligible for distribution, then you are not permitted to offset the account balance and you have a deemed distribution instead of an actual distribution.

If you have an actual distribution, then you no longer have to consider the loan at all - it was essentially an in-service withdrawal. Your maximum loan amount would be $10,000.

If it was a deemed distribution, then your analysis is correct except Q&A 19 specifies that the loan must continue to accrue interest. The loan balance (with accrued interest) might now be $12,000. Your balance would then be $32,000, your maximum total loans would be $16,000, your already outstanding loan would be $12,000, and your maximum new loan would be $4,000.

[MR]

PC, it is a deemed distribution, so I'm comfortable that the methodology is correct, but I have a question regarding the accrual of interest. I don't have the new loan regs handy, so I'll be lazy. I thought the accrual of interest was for purposes of determioning the highest outstanding balance within the last 12 months. This would be used to calculate the maximum available amount with respect to the $50,000 cap. Am I incorrect on this?

thanks.

[Guest PC]

The regs state (in part) "In the case of a loan that is deemed distributed under section 72(p) and that has not been repaid (such as by a plan loan offset), the unpaid balance of such loan, including accrued interest, is considered outstanding for purposes of applying section 72(p)(2)(A) to determine the maximum amount of any subsequent loan to the participant or benefitciary."

Section 72(p)(2)(A) limits the total of all outstanding loans to the lesser of (essentially) (i) $50,000 or (ii) one-half the vested accrued benefit.

There is a rule in 72(p)(2)(A)(i) that also reduces the $50,000 by the highest outstanding balance in the past 12 months that you are probably thinking of.